Headwinds Dominate To Start The Year

Disconcerting news about the economy and the markets is inescapable as surging inflation, the Russian war on Ukraine, and capital market volatility dominate the news. It’s not surprising that some investors are on edge. Today we will put some of this recent volatility into perspective. 

I think it is important on the front end to differentiate between how these events impact a long-term investor versus a short-term trader. Just as the 100-meter dash and a marathon are both racing competitions, trading and long-term investing are two approaches to investing money. Trading strategies generally focus on short-term objectives and frequent buying and selling. Traders often look to turn a profit in a short period of time by closely monitoring market price fluctuations. Investing is a strategy geared toward managing and growing wealth in the market over a longer period. This means that securities are purchased with a longer-term outlook in mind. 

A “trader” might certainly make some dramatic portfolio moves in this environment based on short-term factors. As long-term investors, we know that recessions and bear markets are a normal part of the equation. If you are a long-term investor, this market activity is uncomfortable, but should not completely disrupt the long-term plan that is in place.

Market Volatility Prevailed In The First Quarter Of 2022

First-quarter statements reflect the negativity of the current investment environment. This will be especially apparent in more conservative accounts where rapidly rising yields caused a level of price deterioration uncommon in the bond market. In fact, fixed income returns for the quarter were worse than large-cap stocks and rank as the third worst in the last 50 years. 

The current investment environment was recently detailed in our First Business Bank Quarterly Market Review. To summarize, both the equity and fixed income markets were unsettled in the first quarter by rapidly rising inflation. Strong consumer spending, fueled by stimulus checks, steady hiring, and pay raises, has collided with supply shortfalls to raise inflation to 7.9% as of February, the highest rate since 1982. This inflation situation was further exacerbated by the Russian war on Ukraine. Russia is a major producer and exporter of crude oil, natural gas, wheat, metals, and fertilizer. Russia and Ukraine together export more than a quarter of the world's wheat. The countries are also key suppliers of barley, sunflower seed oil, and corn. World food prices jumped nearly 13% in March to a record high.

To check rising inflation pressure, the Federal Reserve has launched one of the most difficult tasks a central bank can attempt: Raise borrowing costs enough to slow growth and tame high inflation, but not so much as to topple the economy into recession. Officials raised rates a modest .25% in March and signaled as many as seven total hikes in 2022, some possibly as much as .5%. Bond rates have surged with the expectation that rates could rise quickly. Yields rapidly adjusted to the new normal as investors factored in the prospect of higher rates. The 2-year Treasury, which started the year at .77%, rose recently to a high of 2.6%. The 10-year Treasury yield rose to 2.72%, hitting a three-year high. The average rate on a 30-year fixed rate mortgage crossed 5% for the first time since 2018. This rate volatility is what caused the significant negative decline in bond values in the first quarter. The aggregate bond market fell by -5.9%, the municipal bond index by -6.2%, and short-term government bonds by -2.5%. On the equity side, the large-cap S&P 500 fell by -4.6%, small-cap stocks declined by -7.5%, and developed and emerging international by -5.9% and -7%, respectively. 

The Dynamics Behind Rate Hikes And Stock Market Performance 

Let’s look at the impact of higher interest rates on the equity markets. Higher rates ripple throughout the entire economy. Consumers are negatively impacted by increases to their credit card and mortgage interest rates. When non-discretionary spending becomes more expensive, households are left with less disposable income. Less discretionary spending money can impact businesses' revenues and profits decrease. Lower revenues and higher borrowing costs can lead businesses to revise or pause plans for expansion. 

Interestingly, stock market returns in the last five rate hike cycles were negative only one time (June 1999 to January 2001). When factored together, the S&P 500 saw a median increase across all five cycles of 30%. 

What Is An Investor To Do?

Our investment team feels that this is an evolving investment environment, one dominated by rising interest rates, higher and potentially rising inflation, and slowing global growth. Our goal is to position long-term investors in a way that protects against, and takes advantage of, this changing market dynamic. Our clients will see this shift, which centers around a reduction in our growth overweight and the inclusion of strategies that are focused on quality, growth in dividend income, and asset classes that provide greater diversification in our portfolios.

Here are a few final thoughts for longer-term investors to keep in mind:

  • Bear market cycles are challenging, but bull market cycles are stronger and more durable.
    • Average bear markets since 1980 lasted an average of 236 days and generated an average return of -28%.
    • Average bull markets since 1980 lasted on average 852 days and generated an average return of +99%.
  • Market timing can be highly detrimental to returns.
    • Quite often the best and worst days happen close together.
    • Nine of the 20 best trading days occurred in years where the market was negative.
    • Eleven of the 20 worst trading days occurred in years with positive returns.
    • Five of the worst 50 days ever, and seven of the best days ever, were within a four-week period in March 2020.

As always, we welcome the opportunity to talk with you about how this market volatility has impacted your investment portfolio.